As a business grows from a hobby or planned venture, it’s important to put thought into structuring it correctly to avoid costly issues down the road. Since establishing or changing the structure of your business will have long-term implications, consult with an accountant and attorney to help you select the form of ownership that is right for your company’s evolving needs.
The purpose of this post is to help you reflect on the vision for your business to help cut down on time spent during a consultation, which ultimately means savings in your pocket. Some of this can also help develop and formalize your business plan. In making a choice, you will want to consider the following:
- Your vision regarding the size and nature of your business.
- The level of control you wish to have.
- The level of “structure” you are willing to manage.
- The business’s vulnerability to lawsuits.
- Tax implications of the different ownership structures.
- Expected profit (or loss) of the business.
- Whether or not you need to reinvest earnings into the business.
- Your need for access to cash out of the business for yourself.
- Legacy Goals: How or if your family will ultimately play a role.
- Succession plans and estate management.
The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibility for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, the owner is the business.
In a partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed. Yes, it’s hard to think about a “break-up” when the business is just getting started, but many partnerships split up at times of crisis, and unless there is a defined process, there will be even greater problems. They also must decide up-front how much time and capital each will contribute, etc.
A corporation—chartered by the state in which it is headquartered—is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.
Subchapter S Corporations (S-Corp)
A tax election only, this form of ownership enables the shareholder to treat the earnings and profits as distributions, and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company, must pay herself wages if there is a profit, and those wages must meet standards of “reasonable compensation.” This can vary by geographical region, as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.
Limited Liability Companies (LLCs)
The LLC is a relatively new type of hybrid business structure that is now permissible in most states, including MA and NH. In short, you get a lot of value from this option. It’s fairly simplistic from an operational and tax perspective AND should limit liability claims to the assets of the LLC. While formation is more complex and formal than that of a general partnership, it’s still a relatively easy registration process. A new EIN will need to be obtained if you’re a multi-member LLC, or your own can be used if a single member. If using your own it will be viewed as a disregarded entity for filing purposes (like a sole-prop). Even as a single member it still may be desirable to keep things separate for account opening purposes, etc. The cost associated with filing varies state to state ($500 in MA and $100 in NH) and is done annually. Also, know that when doing business in a specific state the LLC not only needs a local address but a residing agent. Because some business owners live across state lines it’s certainly possible to name a representative agent, which is often an attorney. Lastly, ask an attorney about transferring the LLC into your trust or a new trust for business succession and/or estate planning purposes. Start here to file in MA!
Pro-tip: you’ll want to ensure you utilize LLC or Limited Liability Company in the company name when advertising to receive the benefits in the event of a lawsuit.
Family Limited Partnerships (FLPs)
A family limited partnership is an entity formed as a statutory limited liability partnership under state law in which the only partners are family members.
In a typical case, parents establish a family limited partnership by transferring investment assets to it. Investment assets can include real estate or stock investments such as the family farm or stock in the family business, assuming the business is a C corporation. Parents can also contribute appreciating property directly to their children and then form a partnership, or simply gift partnership interest in their business to their children directly, after contributing property to the partnership. Recently they’ve come under scrutiny, particularly in MA, so it is wise to work with an estate attorney that stays current on FLP case law and recent rulings.
About the Author
Quentara Costa helps the sandwich generation prioritize kids, self, and aging parents. For years Quentara was the primary caregiver for her father who was diagnosed with Alzheimers at the age of 70. Since his passing she’s become a mother of two sweet girls. Professionally she received a master’s degree in Personal Financial Planning from Bentley University and has held the CFP® designation since 2010. Community involvement includes hosting the Merrimack Valley Senior and Caregiver Group and volunteering for Budget Buddies.Schedule A Free Consultation